An inverted yield curve could be on the cards in the near future if recent trends in bond markets continue, but it might not signal a recession this time around, according to Adrian Hull at Kames Capital.
Rising short rates in the US are currently outpacing moves at the long end, flattening the yield curve, with market participants expecting further moves in the same direction. Traditionally over the last century, such an inversion of the yield curve has been seen as the amber light for a forthcoming slowdown, but Hull says the outlook this time is far less clear.
“The Fed is spending a lot of time worrying about what an inverted yield curve might mean for expectations as well as economic reality,” Hull says.
“Today, the sophisticated world of central banking and generic 2% inflation targeting provides stability; but as Quantitative Easing stops and the unwind drips the stock of bonds back to the market, we are in unchartered territory.”
Hull, co-head of fixed income at Kames, says as a result investors might have to look further back than the most recent history to give a better indication of the consequences of an inverted yield curve.
“Analysis from BNP Paribas shows that up until the 1930s the yield curve was almost always inverted. Perpetual gilts traded at a premium to short dated “call” money,” he says.
“Essentially, those people who had money didn’t want the hassle of chasing higher yields from the lightly regulated banking system. They were happy to stay safe with gilts and let those who really needed money squabble for it at higher yields.
“No doubt this is a somewhat simplistic view of the materially less regulated world of late 19th century bond markets, but there are parallels with today. Regulation demands that a whole chunk of pension fund money is locked away for the long term in safe assets almost irrespective of the cost of call money, which is creating (as we have seen many times, and continue to see in long gilts) an inverted yield curve.”
Hull says as a result of these changing dynamics caused by extraordinary central bank policies, this time an inversion might not be such a portent of tough times to come.
“What if the patterns over the past almost hundred years are wrong? What if it’s different this time?” Hull says.
“It might just be a little too easy to assume an inverted yield curve means upcoming recession this time around.”